On July 22, 2015, the United States Treasury Department and Internal Revenue Service (“IRS”) released proposed regulations under Section 707(a)(2)(A) of the Internal Revenue Code (the “Code”) regarding disguised payments from partnerships to its partners for services (the “Proposed Regulations”). The Proposed Regulations apply to any arrangement between a partnership (e.g., limited liability companies and limited partnerships that are often used as investment fund vehicles) and a partner that provides services to the fund in exchange for a partnership interest, including management fee waiver provisions found in many private equity and other investment fund agreements.
Management fee “waiver” mechanisms generally
Although there are many different types of management fee waiver arrangements, they generally involve a waiver by the fund manager of all or a portion of its management fee in exchange for a “profits interest” granted to the manager, the general partner or another affiliated partner. In some arrangements, the amount received from the profits interest is equal to the waived management fee (if the fund has sufficient profits). In other arrangements, each reduction in the management fee is treated as if it were contributed to the fund, and the amount received from the fund in respect of a contribution will be more or less than the waived management fee depending on whether the investment is sold at a gain or a loss (i.e., the proceeds could be more or less than the amount waived). As part of the arrangement, the capital contribution obligation of the general partner (or another affiliated partner) may be reduced on a dollar-for-dollar basis in an amount equal to the waived fee, and limited partner contributions that would have been used to pay the waived fees would be available to the fund as if the general partner (or another affiliated partner) had made its full contribution.
Management fees are typically taxed to the fund manager as ordinary income, and carried interest is generally taxed as long-term capital gains (since carried interest retains the character of the income earned by the fund, which is typically long-term capital gains). Thus, management fee waivers typically result in the conversion of ordinary income taxed at federal income tax rates up to 39.6 per cent to long-term capital gains or qualified dividend income taxed at federal income tax rates up to 23.8 per cent (including the 3.8 per cent tax on net investment income.)
Management fees may be waived in different ways. For example, in some funds management fees may be “waived” prior to the beginning of the period for which those fees would otherwise be earned (e.g., annually or quarterly), and in others the management fee waiver and the recipient’s entitlement to allocations and distributions are determined by formulas set out in the fund agreement (often referred to as “hardwired”).
The proposed regulations
Section 707(a)(2)(A) of the Code grants the Treasury Department authority to issue regulations under which a purported allocation and distribution to a service partner are recharacterized as a “disguised” payment for services and consequently treated as ordinary income. The Proposed Regulations generally adopt a facts and circumstances test and provide a non-exclusive list of six factors to consider when making the determination. However, the Proposed Regulations provide that an arrangement that lacks “significant entrepreneurial risk” (determined at the time the arrangement is entered into and at the time of any subsequent modification) will in all cases be recharacterized as a payment for services. The Proposed Regulations describe certain facts and circumstances that create a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services, unless other facts and circumstances establish by clear and convincing evidence that significant entrepreneurial risk is present. The facts and circumstances that create a presumption that significant entrepreneurial risk is lacking are:
- capped allocations of income if the cap is reasonably expected to apply in most years;
- an income allocation for one or more years is reasonably certain;
- an allocation of gross income;
- an allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all facts and circumstances, or is designed to assure sufficient net profits are highly likely to be available to make the allocation (e.g., because the agreement only allocates net profits from certain periods or transactions and does not depend on the long-term success of the enterprise); and
- an arrangement in which a right to receive payment for future services is waived in a manner that is non-binding or fails to notify the fund and its partners of the waiver and its terms in a timely manner.
Although only one example is in the Proposed Regulations is reasonably close to market practice for management fee waivers, the examples suggest that a waiver containing the following elements should be respected:
- Cumulative Net Income. Allocations and distributions in respect of the profits interest arising from the fee waiver are made out of (and only to the extent of) cumulative net income and gain over the life of the fund.
- Clawback. The recipient’s agreement to return to the fund any distributions that ultimately are not supported by allocations of cumulative net income and gain (provided it is reasonable to believe the partner will comply with the clawback obligation).
- Binding Waiver and Notice. A fee waiver that is binding, irrevocable, and made in advance of the taxable year in which the fees would be earned (60 days before the beginning of the year in the examples), where the service provider notifies the fund and all of its partners of the waiver and its terms.
An arrangement that is characterized as a disguised payment for services will be treated as a payment for services for all federal tax purposes. Accordingly, the deferred compensation rules of Sections 409A and 457A of the Code and employment and withholding tax rules could be implicated.
The preamble to the Proposed Regulations states that the Treasury Department and IRS plan to amend the existing profits interest “safe harbor” guidance (Revenue Procedures 93-27 and 2001-43) when the Proposed Regulations are finalized, to exclude a profits interest issued in exchange for services in conjunction with foregoing a payment of a substantially fixed amount. Any issuance of a profits interest not within the safe harbor would be governed by the existing case law that does not provide clear guidelines regarding the valuation and treatment of a profits interest.
In addition, the preamble indicates that the Treasury Department and IRS are of the view that issuing a profits interest for services to a person other than the service provider (e.g., fee waiver arrangements where the manager waives the fee but an affiliate receives the profits interest) does not qualify for the existing profits interests “safe harbor.” Thus, profits interests should be granted to the party that waived the management fee.
The Proposed Regulations will apply only to arrangements entered into or modified on or after the date final regulations are published in the Federal Register. However, the Treasury Department and IRS have indicated that they believe that the Proposed Regulations generally reflect Congressional intent. Therefore, the IRS may challenge existing fee waiver arrangements prior to the Proposed Regulations being finalized. In addition, if an arrangement permits a service provider to waive its fee after the date the arrangement is entered into, then the arrangement would be considered to be modified on any date that the fee is waived. As a result, fee waivers that are made on a quarterly or annual basis rather than “hardwired” at inception of the fund would be treated as modifications upon each quarterly or annual election.